Tuesday, July 12, 2011

What caused the recent Great Recession?

Ron recently complained about Ben Bernanke. In particular, he shared his own theory of who is to blame for the recent bad US (and world) economy (high unemployment, fall in GDP):

The housing crisis was not an unexpected aberration, it was the completely predictable result of the systematic dismantling of the tax and regulatory regime that was in place in this country since the end of WWII [...] The predictable result was increasing financial instability and economic inequality. Since 2008 we have done absolutely nothing to change the strategic situation so it shouldn't come as a surprise to anyone that we continue to see the same results.

I disagreed with this analysis, and there was some lively debate in the comments.

Scott Sumner (my economist hero blogging at The Money Illusion) has recently posted what I think is an excellent summary of the real issue about assigning this blame correctly:

Progressives tend to blame the instability of unregulated capitalism, prone to bubbles and crashes. Conservatives blame moral hazard created by government insurance and/or policies that tried to get more low income people into housing. But both seem to see the sub-prime crash as the proximate cause of the crisis of late 2008. I think they are both wrong. [...] I’m depressed by almost all discussions of the current crisis, as they all start with the premise that “it goes without saying” that the Great Recession was triggered by financial crisis. No, the Great Recession caused the financial crisis.

It's true that the first obvious sign we all saw, back in 2007, was the bubble in housing prices, and then the collapse of subprime mortgages. But people on "both" sides of the political debate seem to spend all their time trying to pin the blame on what led to the subprime collapse, as though the subsequent (worldwide!) Great Recession was a necessary consequence, once the mortgage crisis began. To avoid such future economic pain (years of high unemployment, low GDP growth), both sides seem to be trying to figure out how to prevent another mortgage collapse. And of course they have wildly different theories on how to go about that.

But Sumner rightly questions the second part of the link. What if it doesn't matter that mortgages collapsed? What if that didn't need to lead to a huge recession? Sure, you can blame the match for starting the destructive wildfire ... but when you see the fully-staffed fire trucks parked right next door, and they decline to intervene to put out the fire as soon as it begins ... well, is the match really the "cause" of the wildfire's destruction?

Suppose the helmsman fell asleep at 2:00am. The ship goes of course. Who’s fault is it–the wind, or the sleeping sailor? I say the sleeping sailor.

(BTW: if you want to know the "real" cause of the recession of the last few years, Sumner has convincingly argued that it happened because the US Fed incorrectly allowed nominal GDP to plummet after the mortgage crisis began. In essence, we didn't have enough inflation; the Fed allowed damaging deflation instead.)